optionMONSTER®

Would you like to...

• Be able to profit from big moves - up or down?
• Take advantage of increasing volatility?

There are times when you just know that a big move in a stock is coming - the problem is that you don't know which direction. Wouldn't it be nice to have a strategy that could profit from such moves regardless if they were up or down?

Long "straddles" and "strangles" fit the bill. The strategies profit from volatility -- sharp moves in the underlying, either up or down. They involve owning both calls and puts on the same underlying asset. These are some of the most expensive options strategies, but the maximum risk is known and fixed. Time decay and drops in implied volatility are the biggest threats to the strategy.

Table of Contents

• What are a Straddle and a Strangle?
• Example of a Winning Trade
• Example of a Losing Trade
• Summary

What are a Straddle and a Strangle?

A straddle entails buying an at-the-money call and the same at-the-money put. The idea is that should the underlying significantly increase or significantly decrease, such that the new value of the call or the put can be sold for more than the cost to purchase the two positions, you profit.

A strangle takes the same approach, but uses an out-of-the-money call and an out-of-the-money put, to reduce the cost. This is a lower-cost trade, but requires an even greater move to be profitable.

Straddles and strangles profit from significant moves up or down in the underlying. A rise in the implied volatility will also increase the value of a straddle or strangle. Because you are paying two premiums, buying time value on both sides, the stock usually has to move considerably to produce big profits. Implementing the strategy simply involves buying a put and call with an expiration that gives the trade enough time to work, and straddle/strangle buyers are best served by not holding their positions as expiration gets close, as that is when time decay is greatest. Finally, the best time to buy options is when implied volatility is low.

This strategy loses if the stock price does not move enough to offset the time decay, or a fall in implied volatility. The maximum risk is the debit paid. If the implied volatility drops, the position can also lose value, even if the underlying moves. This is the reason that buying straddles or strangles before earnings (or other news) can be a risky strategy. Even if the stock moves, the drop in implied volatility that often happens after earnings are released can more than offset the gain from the move in the underlying.

This example uses a 26 straddle bought for $2.23, with the stock at $26.25. (Note that the option strike is unlikely to be exactly the same as the share price.) The position shows a profit if as expiration nears the stock price has moved beyond the strike prices used, plus or minus the debit paid to establish the call and put positions (26 +/- 2.23).



The position will profit from significant moves up or down in the share price. The longer the move takes to happen, the bigger it needs to be, to offset time decay in the option price. Because implied volatility is a significant part of the premium paid for an option, if implied volatility goes down, the straddle will lose value and if implied volatility goes up, it will gain. This is only the case before expiration, because at expiration profit and loss is fixed. Time is against you with a straddle or strangle. You have a position with significant negative theta and so every day you are losing value from time decay.

Example of a Winning Trade

• In the circled area, the price of Intel (INTC) bounces off a low while implied volatility stays low. Ideally we want to buy straddles on low implied volatility.
  
  
• Time decay is the opponent of the straddle and the greatest in the last month before expiration, so we need to give ourselves time to be right. In this case, with the stock climbing back above $25 and implied volatility at 30%, we would buy three months out, choosing the February 25 straddle.
• Within two weeks, the stock hit $28 and implied volatility went up to 34%. The call tripled in value, while the put lost much of its value.
• To exit the position, the straddle could have been sold in its entirety for a nice gain. When a position doubles in value, we generally consider closing half the position, so that no matter what happens next, we would break even.
• Alternately, the call could have been sold and the put held, in case there was a pullback. As can be seen from the chart, in fact the stock fell as low as $19 before the February expiration, meaning the put also would have given a 300% gain.

Example of a Losing Trade

• If we had bought a straddle a month earlier, the trade would not have worked out as well. Two things can go against us in buying straddles: implied volatility can go down, and time decay can eat away at the position.
  
  
• In the highlighted area we see INTC breaking out to a new high. Enticed by current moves, many options traders ignore implied volatility and buy out-of-the-money options only in the near months.
• So with the stock at 26.50 and the implied volatility at 41%, we would have bought the November 27 straddle.
• The price did move up to 27.50, but with time decay and the drop in implied volatility, the position showed a loss. The price then fell and took the straddle value down to a 50% loss.
• At that point, we would have exited the trade, since we generally consider that any position should be closed when it loses 50% of its value.

Summary

• Straddles and strangles are delta-neutral, meaning we don't care if the price goes up or down.
• They are a limited risk, but very expensive strategy.
• They are significantly affected by implied volatility and time decay.
• The maximum risk is limited; the maximum gain is theoretically unlimited.

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Options data for ActionTracker provided by Wolverine Trading Technology, LLC. Market data powered by QuoteMedia, fundamentals by Hemscott. All data delayed by 15 to 20 minutes unless otherwise indicated.

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Copyright © 2010 OptionMonster® Holdings, Inc. All rights reserved
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